A Wall Street analyst just nailed the most important thing we don't know about China's economy

Chinese officials will be attending a huge economic conference in the coming days, and since the country’s growth has been slowing significantly for a little over a year, they will have a lot of problems on their minds:

It’s on that last point where we find the most urgent, complicated and mysterious issue with China’s transitioning economy right now. For months the government has said that it is committed to restructuring the country’s corporate sector, especially State Owned Enterprises (SOEs), but officials have been light on actual concrete plans.

And the problem with that, says Societe Generale’s analyst Wei Yao, is that we don’t know how long the country can hold on.

“If the government were to kick start restructuring, NPL [non-performing loan] recognition and write-offs would speed up and the probability of credit events would increase. There is a tight rope to walk here,” Yao wrote in a recent note.

“Having the central government bail out every zombie company and pay for the whole restructuring would not only be very costly to Chinese consumers (the taxpayers) but would also exacerbate moral hazard, thus impeding long-term positive developments of domestic capital markets. However, there is no formula on how much credit risk China’s financial market can handle by itself without plunging into a full-blown crisis [emphasis ours].”

China is transitioning from an economy based on investment, to one based on domestic consumption. It’s a difficult trick to land and means that sectors that used to be economic drivers — like the property market and manufacturing — are bound to decline. The thing is, if China is going to get through this, it needs its people to spend money, not lose their jobs or have their wages cut because they’re working for companies within sectors on the decline.

That’s part of why restructuring corporates is so necessary.

Now. Not later.

“Consolidating zombie SOEs is an ever-more pressing task now that the economic and financial pain of excess capacity is approaching a critical level,” Yao wrote.

It’s a pretty simple concept. If Chinese companies are spending their money paying off debt, they’re not growing and investing in the economy. They’re not hiring. They’re not making solid profits.

If the market thinks the government is going to bail everyone out, however, the market is also going to let companies keep borrowing at low rates, exacerbating the problem. That’s why China’s corporate bond market has exploded over the last couple of months.

Corporate defaults in China are super rare. There have only been six this year, and most of them have been smaller companies, not big SOEs. The market doesn’t see a reason to stop lending them money, and China’s Central Bank has been keeping rates low overall to spur the economy on anyway.

What’s more, Chinese banks have just stopped recording NPLs in order so they don’t have to hold more cash on hand, according to Reuters.